August 26, 2008

Russia – Tough Investment Environment

by ssavage

By Johnston, Daniel

This article relates the saga of the Sakhalin II project, one of the earliest of the Russian production sharing agreements. An offshore oil and gas field development in the Sea of Okhotsk off the eastern shore of Sakhalin Island, Russia, the Sakhalin II project embodies many of the key issues of the day in the former Soviet Union (FSU). It involves the Piltun-Astokhskoye and Lunskoye fields. Piltun-Astokhskoye is primarily an oil field; Lunskoye is primarily gas. The two fields contain an estimated 1-1.2 billion barrels of recoverable oil and 14-18 TCF of natural gas. The Sakhalin II production sharing agreement (PSA) dated June 22 , 1994(1,2) was the first of three Russian PSAs (followed by the Sakhalin I and Kharyaga PSAs). Sakhalin II has been described as "an agreement so advantageous it becomes part of corporate lore and is analyzed in business school textbooks for years to come."3 One common explanation is that the government agreed to forego its share of the revenues until the international oil companies (IOCs) had recouped their costs.4,5

There is the added claim that the Sakhalin PSA structure transferred "most of the risks of both construction overspend and change in the oil/gas price to the Russian government."6 This statement is fortified by the claim that the government did not foresee the long delays and increase of projected costs that have afflicted the project.7

Other issues prominent in the Sakhalin II story include allegations of environmental abuse and lack of compliance with the Russian 70% "local content" requirement. The key issues and claims associated with the Sakhalin II PSA boil down to:

* It is overly advantageous to the IOCs;

* The government must forego share of revenues until the IOC recoups costs;

* Risk of cost over-runs and price volatility are shouldered mostly by government;

* Russian 70% local content requirement not being met,8 and

* Environmental abuses exist at Sakhalin II development.

The first three srguments were pillars of YUKOS chairman Mikhail Khodorkovsky's position when he lobbied against PSA legislation in Russia in the late 1990s. His efforts were based in-part on comparison of PSAs with royalty/tax systems.9

Other claims of lopsidedness in the Sakhalin II PSA are fortified by comparison to a "standard" PSA.10 However, comparing the Sakhalin II PSA with either a standard PSA or with a typical royalty/tax system is misleading. Alternatively, in Table 2 a comparison is made with another large-scale, frontier-type LNG project-Tangguh LNG in Eastern Indonesia. Indonesians have considerable experience with both PSAs as well as grassroots LNG project development. Tangguh LNG is the third such project in Indonesia following the Bontang and Arun LNG projects which came on-stream in 1977 and 1978 respectively. Tables 1 and 2 below summarize key aspects and terms of the two projects and the underlying agreements. This comparison of key economic indicators for these two projects indicates the similarities outweigh the differences on most of the issues outlined above.

Tangguh LNG

The Tangguh project is comprised of three (now unitized) contract areas: the Berau, Muturi, and Wiriagar PSCs in the Bintuni Bay area of Papua, Eastern Indonesia. Final approval from the government of Indonesia and partners took place in March 2005. The total cost of the project was estimated at around $6 billion," not including tankers and re-gas facilities.

The Tangguh project encompasses six gas discoveries, Vorwata, Wiriagar deep, Roabiba, Ofaweri, Wos, and Ubadari with around 14.4 TCF gas. Production will come from two normally unmanned offshore production platforms located in Bintuni Bay.

Table 1

Technical Comparison of Sakhalin and Tangguh Projects 12

Table 1

Technical Comparison of Sakhalin and Tangguh Projects 12

Table 2

Fiscal Comparison of Sakhalin and Tangguh Projects

There is considerable mention in the industry literature of how the Russian government must forego a share of revenues at Sakhalin II until the IOCs have recouped their costs (plus interest).33 However, during the capital cost recovery phase of this project the Russian government receives a 6% royalty. Under the Eastern Indonesian PSAs (for gas) the government is guaranteed only around 4% of production during the cost recovery period (plus interest).34

It appears at times that the implication is the IOCs at Sakhalin have an incentive to spend more than they otherwise would (called "goldplating") or at the very least there is not sufficient incentive to keep costs down. However, the risk of cost over-runs is captured to a large extent with the savings index. Like most petroleum agreements around the world, if costs increase then there is a reduction in total available profit oil or gas and/or taxable income. As both the government and the IOC have claim to a share of profits, they both stand to suffer to some degree. The savings index measures that. In the Sakhalin and Eastern Indonesian gas agreements, the IOCs have claim to around 34% to 37% of the after- tax profit oil or gas-no real difference. If there is a cost overrun, the governments shoulder most of the burden (66-63%) and the companies shoulder the rest. Therefore, this index shows why governments (in both cases) are concerned about keeping costs down. But so are the oil companies. Furthermore, the oil companies' incentive is magnified when present value discounting is factored- in,35 and this is not shown in Table 2. So it is clear that the IOCs at Sakhalin (and Tangguh) have an incentive to economize (within reason-considering health, safety, and environmental issues). The reality is that costs have been increasing for most goods and services. LNG manufacturing costs have increased nearly five-fold, and much of this trend is shown in Appendix 1. The Sakhalin project is notoriously over-budget but considering the harsh arctic environment and relatively remote location (compared to Tangguh), it is not surprising. Sakhallin LNG has a hefty temperature advantage. Cooling the methane gas to below 162[degrees] Celsius is much easier when the mean annual surface temperature is close to 1[degrees] Celsius as it is at Sakhalin. At Tangguh the average temperature is around 12[degrees] Celsius.

The Russian content requirement of 70% (which is part of the PSA) is a noble ambition. However, it is hard to imagine that the Eastern Russian provinces have the technology and workforce to adequately supply up to 70% of the goods and services (and 80% of the labor force)36 needed for a state-ofthe-art, harsh-environment, frontier LNG development. Part of the explanation for IOCs lack of compliance with the local content requirement is that the IOCs don't care about keeping costs down, so they have no incentive to use lessexpensive local companies.

Claims of environmental abuse are particularly inflammatory these days. For many industry personnel who have worked in the former Soviet Union the claims must seem odd. However, in 2005 the European Bank for Reconstruction and Development (EBRD) said of the Sakhalin II project that it lacked "environmental awareness" and, unless the operator improved environmental protection measures, funding would be withheld.37

One of the problems with the Sakhalin II agreement unfortunately- and probably unexpectedly-is self imposed because of public statements regarding the virtues of the agreement from the IOC point of view. In 2002 Steve McVeigh, CEO of the Sakhalin Energy Investment Company (SEIC), claimed the Sakhalin IIPSA had "some of the best terms you will ever get in Russia."38 To many in the petroleum industry this isn't saying much., but statements like this are being used against SEIC. The Harvard Business School claimed that Sakhalin II was widely considered to be favorable to SEIC and that the agreement was "designed to be attractive to the investors."39 Frankly, for an industry practitioner this would sound reasonable because Eastern Russia is a particularly harsh frontier environment that required attractive terms to make an LNG project work.

By 2000 the Sakhalin II consortium-SEIC was comprised of Shell (55%), Mitsui (25%), and Mitsubishi (20%). In December 2006 Gazprom acquired a controlling interest in Sakhalin II. It had intended to take a 25% interest plus one share which would have given it veto power. However, just before this acquisition was consummated the Sakhalin partners reportedly changed the charter with respect to passmark voting thresholds without informing Gazprom.40 Whether true or not, this story is important for the issue it highlights. Many governments these days are finding that their power and control is or can be mitigated because of the nature and structure of the agreements between consortium members whether it is a charter or a joint operating agreement. Key examples these days include provisions dealing with rights of first refusal, area(s) of mutual interest, sole-risk, unitization, and passmark voting rules.

The most cogent complaint about the Sakhalin IIPSA is the nature of the rate-of-return (ROR)-based profit oil/gas split and more precisely, the first ROR threshold of 17.5% (real). This means that before the government receives much more than the minimum share of 6% (due to the royalty) the IOCs must receive their money back and a real rate of return of 17.5%.

During the mid-to late 1990s ROR-based fiscal systems began to fall from favor in the industry with claims of potential "goldplating". Even Papua New Guinea where the approach was first proposed41 has turned away from their ROR-based elements. While Sakhalin II is the most glaring example of problems, the Russian government has put considerable pressure on the other large-scale Western oil projects in which the government does not have controlling interest: Sakhalin I; BP's (BP-TNK) venture, Total's Kharyaga; and the Caspian Pipeline Consortium (CPC), which exports Kazakh oil through Russia to the Russian Black Seaport of Novorossiysk.

The action in Russia prompted one analyst to state that the future for foreign oil companies in Russia "does not bode well."42 This statement though implies Russia's past (presumably since the breakup) had some bright moments-although it is hard to find evidence of this.

The bottom line is this: The Russian people were neither outwitted nor victorious with the original Sakhalin II agreement. The same is true for the IOCs. It was a fair and reasonable deal. Furthermore, it was consistent with industry standards and practices in that it aligned the interests of the various parties in important ways that ordinarily promote a healthy business relationship. Yet, ultimately the relationship deteriorated. This is because most of the political pressures brought to bear on this project resulting in a virtual takeover by Gazprom were based on false logic. This problem is not unique to the Sakhalin II situation. Numerous debates are underway world-wide over the relationships between IOCs and governments. Unfortunately, mis-information and populist rhetoric often prevail as we have seen with Sakhalin II.

Numerous debates are underway world-wide over the relationships between international oil companies and governments. This article relates the saga of the Sakhalin II project, an offshore oil and gas field development in the Sea of Okhotsk off the eastern shore of Sakhalin Island, Russia, and one of the earliest of the Russian production sharing agreements. Ultimately the relationship deteriorated. This is because most of the political pressures brought to bear on this project resulting in a virtual takeover by Gazprom were based on false logic. This problem is not unique to the Sakhalin II situation. Indeed, the Sakhalin II project embodies many of the key issues of the day in the former Soviet Union (FSU).

2 The term "production sharing contract" did not translate well in the Russian language/culture. As a result the term "production sharing agreement" came into wide use once such agreements came into use in the FSU. Otherwise there is no difference between a PSA and a PSC.

30 The (real) internal rate of return hurdle rate (17.5%) at Sakhalin II behaves much the same as the interest cost recovery under the Indonesian PSCs, i.e., government share of production or revenues only begins to increase after costs have been recovered plus interest 17.5% real at Sakhalin and 9% nominal at Tangguh.

31 A. Damodaran, "Value Line Database," (January 2008, accessed January 23, 2008) < new_home_page> Here it is assumed that the Tangguh LNG project is structured the same as Indonesia's Bontong LNG with regard to interest cost recovery. The 9% interest is based on the industry standard we33333ighted average cost of capital (WACC) formula. The cost of equity, percent equity, after-tax cost of debt, percent debt, and weighted average cost of capital for the petroleum (integrated) industry sector are taken from "Cost of Capital by Sector," Value Line Database, January 2007. >

34 In the 1994-vintage E. Indonesian PSCs there is no royalty except the 15-20% first tranche petroleum which acts like an 80-85% cost recovery limit which, in conjunction with the profit gas split, guarantees around 4% to the government each and every accounting period.

42 Andrew Kramer, "A Mix of Oil and Environmentalist!!," Pacific Environment (October 6, 2006). "The official rhetoric is getting steadily more shrill and does not bode well for the future of foreign oil companies in Russia," the director of Goldman Sachs's Moscow office, Rory MacFarquhar, wrote in a note to investors recently. "We continue to believe that the aim of this campaign is to force the foreign companies to accept Russian state companies as equal or even majority partners in their projects, possibly for no compensation."